Hurry Up (raise rates while you can)
As we said in May’s mid-monthly update, monetary policy is about being seen to be doing something in the face of steep increases in inflation in developed economies. The reality is that central banks are more concerned with tight labour markets and wage pressure than the recent rises in CPI as a result of higher energy and food prices which are equivalent to a tax on consumers’ discretionary spending. The window to engineer a soft-landing for the US economy is shrinking and has shrunk further after last Friday’s release of US Consumer Price Inflation (CPI). The window to raise base rates in the UK and not effect a recession is much smaller. Here are the monthly changes from last Friday’s US CPI report sourced from The Daily Shot.
On 15 June, the US Federal Reserve (Fed) raised the Fed Funds rate by 0.75% (75bps) to 1.5% to 1.75% which was effectively baked in to markets after last Friday’s CPI report. Nevertheless, the Fed’s third rate hike of 2022 represents the largest single move since 1994. If only they could influence supply chains. The flexible approach to monetary policy is over, for now. Given the headline of this update and the narrowing window to effect monetary policy through interest rate increases, the Fed understandably talked tough in the post-meeting release, intimating another 75bps at the next meeting in July. The aim is to bring about a demand shock and thus, lower prices. Doing so without triggering a recession is a fine balancing act. Voting intentions are heavily influenced by the state of the US economy and the mid-term elections in November are not too far away.
What would help the Fed, would be an increase in unemployment to take pressure off wages. Meanwhile, the savings rate continues to plummet and credit card usage and balances rise. With mortgage rates over 5%, the housing market should cool and ‘gas’ prices over $5 per gallon ($6 if you live in California), are hitting Americans’ pockets. Equity markets, fearing a greater prospect of recession rather than a soft-landing for the US economy, sold off sharply, undoing the relatively stable start to June.
US consumer sentiment has also nosedived as the following graph from NS Partners shows (consumer sentiment is the amber line):
For those seeking silver linings, US goods inflation which has lead the inflation picture, shows continued moderation as shown by the following graph from NS Partners:
This might be down to an inventory glut caused by over-ordering earlier this year/late last year as the following two charts from Bloomberg illustrate. Ford has just reported auto-loan delinquencies rising and US retail sales in May showed a fall – the first in 2022. The inventory glut has also prompted retailers to cut prices in attempt to reduce inventories.
Mind The Gap
Unsurprisingly, bond markets sold off on the prospect of higher rates and inflation. Non-government spreads have widened too. Another concern over widening spreads has been in Europe where the change in monetary policy voiced by European Central Bank (ECB) Chief, Christine Lagarde, has prompted a widening of Italian government bonds to their German counterparts. In an attempt to nip that spread widening in the bud, the ECB arranged a crisis meeting to construct a ‘tool’ to prevent pressure building on peripheral Euro government bonds. The announcement of the ad hoc meeting was enough to halt the widening for Italian government bonds for now:
Economic growth is already weak in the UK as April’s Gross Domestic Product (GDP) numbers highlighted:
While there was a headline this week about the fall in real wages; wages increased by 4.1%. The problem is that inflation is much higher. The UK government will be keen to limit public sector wage increases. Industrial action is already kicking in. Ten year gilt yields which had until recently been reluctant to go above 2%, surged to 2.5% in June. Painful for holders. The chart below from FT.com illustrates the speed of the move.
The Bank of England Monetary Policy Committee meets today and will have announced a bank rate hike by the time you read this. A half point rise is likely as the Bank attempts to regain some credibility.
The US dollar strengthened on the prospect of higher than expected interest rates. Sterling was weaker on poor political leadership and recession prospects within a stronger US currency narrative and the Japanese yen continued to suffer from speculators. The yen is now extremely competitive for Japanese exporters versus their Chinese and US counterparts. Digital currencies were hit hard. Gold, which we own as an alternative currency, ebbed and flowed on risk awareness but ended mid-month roughly where it started June.
Industrial commodities were relatively stable over the first half of June in aggregate. Agricultural commodities weakened after a strong performance period previously.
We retain our defensive stance, avoiding debt, credit and duration. While yields have risen sharply, we do not feel the need to catch falling knives in that asset class or any other. Equity exposure is focussed on quality which has typically fared relatively well in uncertain markets. Thematically, the biggest theme continues to be energy transition, climate change and related themes such as materials, where the long-term story and following winds from governments remains intact. Commodities (industrials, agricultural and gold) and cash continue to be used as the balance in portfolios rather than the asset management industry norm of debt. There have only been minor cosmetic changes to the portfolios in June to date.
We thank you for your continued support in these uncertain times for financial markets. If you have any questions, please do not hesitate to contact the TBAM team.